by Will Ashworth | April 11, 2012 9:15 am
Monday was a resounding victory for AOL (NYSE:AOL) and CEO Tim Armstrong with the announcement that it’s selling 800 noncore patents to Microsoft (NASDAQ:MSFT) for $1.06 billion. Most important, it said a majority of the proceeds would be distributed to shareholders later this year.
How it does this is very much up for debate. But I think the sensible thing is to pay a special dividend rather than initiating a large regular one or launching a share repurchase program.
InvestorPlace contributor Tom Taulli wrote an interesting article April 10 suggesting that now more than ever, AOL is a very tempting short. He’s absolutely correct to assert that the patent sale doesn’t fundamentally change anything at the company, so if you were shorting or thinking of shorting last week, you should be doubling down today because AOL’s stock is 40% more expensive than it was prior to the announcement.
What I think the patent sale is most indicative of is the type of chief exec Armstrong is and will become over time: someone willing to make the hard choices for the benefit of all shareholders.
While many thought AOL would be able to generate no more than $300 million from its patents, it delivered three times that amount. Starboard Value, one of AOL’s largest shareholders and a thorn in its side, argues that management is wasting money on hyperlocal news service Patch and the rest of its display advertising business. It further wonders why the entire proceeds of the patent sale, which are expected to be 100% tax-free, aren’t being distributed to shareholders.
Frankly, unless Starboard wants to pony up the cash to buy more than 5.4% of AOL’s stock, it has a lot of nerve telling management and the board what to do.
According to Starboard’s own calculation, AOL should have $15.35 in cash once the deal is complete, $11 of that from the patent sale. If AOL were to distribute $7.68 (50%) of its cash to shareholders in the form of a special dividend and its stock was $20 by the time the deal closed, existing shareholders would receive a 38% yield.
Anyone who’s held this stock for the last several years (there can’t be many) has to be salivating at the thought. But Johnny-come-lately Starboard thinks it and the rest of the shareholders should get 100% of the patent proceeds. I say stop whining and be grateful. Activist investing, thanks to firms like Starboard, has given the movement a bad name. I’d be a lot more sympathetic if Starboard owned 15% of the company, as Bill Ackman does in the case of Canadian Pacific (NYSE:CP).
Once a company starts paying a quarterly dividend, it’s hard to stop. Just look at the Dividend Aristocrats. While many consider it a badge of honor to be on the list, dividend payments can become a noose around the neck of a company struggling with cash flow. When it does the right thing by cutting, suspending or eliminating its dividend, its share price craters.
Given the dire picture Starboard likes to paint of AOL, it seems odd that it would push for a $1 billion payout. Despite its assertion that AOL is a terrible allocator of capital, it seems to me that Armstrong & Co. are acknowledging that while it needs to maintain some cash reserves — for future growth, acquisitions, etc. — it also understands that shareholders deserve to be significantly rewarded for their patience.
In my opinion, any quarterly dividend it initiates once the deal for the patents is completed should represent no more than 1% of the yield at that time. At $20, we’re talking about 5 cents on a quarterly basis for an annual payout of $20 million.
Warren Buffett recently admitted that Berkshire Hathaway (NYSE:BRK-B) would buy back its stock up to 110% of book value. If AOL were to apply the same standard, it could pay up to $25.36 a share. With its share price almost there already, a buyback would most certainly drive the stock price well past 110% of book.
But this strikes me as the least beneficial way to reward shareholders, especially after its stock has jumped by 40% in the last couple of days. Supporters of buybacks believe their tax-deferred nature combined with a boost in earnings per share (thanks to fewer shares outstanding) provide the perfect balance between stimulating its share price and allocating capital in a tax-efficient manner.
It all sounds good in theory, but in practice, it rarely works. Most companies end up paying way too much for their stock, and although I think AOL is still reasonably priced even after Monday’s spike, Murphy’s Law inevitably will drive its stock price lower. As far as I’m concerned, the only people who benefit from share repurchases are the named executive officers through their long-term incentive plans.
What should Tim Armstrong do? Consider paying two special dividends of $3.84 a share each, with the first payable upon receiving the cash and a second payout six to 12 months later. This gives shareholders a reason to stick around.
Second, initiate a regular quarterly dividend of 5 cents a share and increase it by no more than 10% annually. In year one, the total cash outlay would be $748 million (including the special dividends) and $21 million in year two, not counting any increase in share count that occurs. This represents 75% of the patent proceeds, far more than anyone thought would be available just one week ago.
As far as I’m concerned, Starboard can take it or leave it.
As of this writing, Will Ashworth did not own a position in any of the stocks named here.
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